Parents or grandparents have a variety of options when it comes to putting money aside for their children and grand children’s college education. One way is a 529 plan, but another way that may be overlooked is a Roth individual retirement account.
Roth IRA’s are a great way to save for retirement, but can also be a good tool to covering college expenses. A 529 plan can only be used to pay for expenses related to college; Roth IRA’s can be used for college expenses and as a retirement income.
For most folks who are sending their kids off to college, only the contribution portions of their Roth IRA balances can be withdrawn tax-free. But Roth IRAs enjoy a rather unique tax treatment. Withdrawals are treated as a “return of contribution” first and as earnings second.
This means that a person who has contributed $5,000 a year for five years can withdraw $25,000 tax free if it is used for a qualifying educational expense, which includes room board, books, and tuition.
Scott Hansen of CNBC News reports that his favorite thing about the Roth IRA is the flexibility it offers compared to a 529 plan. If you put money for a child’s college education in a 529 plan and that child decides not to attend college, it becomes fully taxable as ordinary income. A Roth IRA allows those who have funds left over after college expenses to switch the money to a retirement income, with no tax penalties.
Many states offer a tax deduction for funds contributed to a 529 plan. If you reside in such a state, the 529 can be an attractive solution. But for the millions who live in the eight states that don’t offer this tax break—including California, Massachusetts and New Jersey—the Roth IRA is both a terrific and flexible alternative.
There are some negatives to a Roth IRA, like contribution limits. The maximum contribution in 2014 was $5500 or $6500 for those over 50 years old. Also, in order to contribute to a Roth IRA you have to have an income, which makes it impossible for retirees to use and those people with high incomes are banned from using this tax tool, a single taxpayer maxes out at $114,000 while a married couple is $181,000.
The most popular college savings option is the 529 plan, which does have great benefits and should be considered. However, many Americans should also look into the Roth IRA as an option for college savings.